Avoiding Home Loan Prepayment Penalties

There is increasing competition being witnessed in the home loan space, which has led to a lot of choice as well as offers for borrowers. The impact is also witnessed in terms of an interest rate war from several players with two of India's biggest lenders SBI and ICICI Bank cutting their home loan rates recently. At the same time, there is also a move towards discouraging borrowers to switch loans because it can mean a loss of customers. One route in which this is done is by increasing the amount of the prepayment penalty levied on the loan so that you end up paying a higher amount on such switches, for example, HDFC Bank increased the prepayment penalty from 2% to 3%, and similarly ICICI bank has a high prepayment penalty of 2.25%. Let's take an illustration to understand the concept of switching home loans.

Illustration

In case of Vinay, he has an existing home loan from a bank. His is a fixed rate loan where the rate of interest payable is 11.75 per cent. The current amount that is outstanding on his loan is Rs 10 lakh and the outstanding period now stands at 14 years. At this stage, Vinay would be paying an EMI around Rs 12,156 to complete his loan in the required time period. He also needs to pay a 2 per cent prepayment penalty for repaying his loan early.

At this point of time, if there is a new offer in the market by another bank that is offering a rate of 8.75 per cent then the question is whether Vinay should go for a change in the loan provider. A quick working shows that a 2 per cent penalty would work out to Rs 20,000 which is an expense for Vinay while the benefit will be in terms of a lower EMI for the same period. The EMI for the new loan will drop down to Rs 10,343, which translates in to a monthly savings of Rs 1,813 for him.

Analysis

In this case, Vinay is benefited by making the switch even after the prepayment penalty because the benefit that will arise over the term of the loan is far higher than the cost that will have to be paid. There can also be a situation where the home loan provider could raise the prepayment penalty to 3 per cent. In that case, a similar working would have to be done for the loan and see whether the switch is actually beneficial. However, this higher rate of penalty is not likely to be applicable for existing home loan owners as in most cases this is applicable for new loan takers. In such a situation, existing borrowers will have to base their workings on the rate that is actually prescribed for them.

The best way to tackle the prepayment penalty would be to go for loans with no prepayment penalty. Not all types of loans have such a penalty. Usually, fixed rate loans have this penalty while floating rate loans are spared from such a condition. Selecting a home loan where this provision is not there at all would ensure that there is no question of any cost when you decide to prepay. This is because you can repay the loan as per your wish and convenience, and there will not be any financial impact involved.

Lower Rate

There might be times when avoiding the penalty is not possible. The best way to tackle such situation is to first check out the actual prepayment penalty rate. The lower the rate the better it is for you, but at the same time when it comes to the question of switching the home loan, the real benefit comes in the form of the new rate applicable. As seen in the above example since there is a large 3 per cent rate differential and the loan amount outstanding is high at Rs 10 lakh there is a benefit to switch. You need to consider the overall benefit over the life of the home loan, and not just the immediate impact. The benefit that comes in over a longer period loan will be higher than the immediate payment that you would make and hence could turn out to be better.